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Thursday, February 29, 2024

Lending money to friends and family: determining when it is right

One of my tennis buddies told me a funny story about borrowing money from his parents. He was 28 at the time and asked for a $30,000 loan to purchase a condominium. Since his parents had plenty of money and didn’t earn much on interest, they thought lending money to him was a win-win situation.

Everything was going well until one day his mother came to his newly purchased condominium. It had been a while since they came to live with him and his mother wanted to talk about the borrowed money.

The mother said, “Paul, your father and I are disappointed in you. It’s been three months since you lent us money to buy your condominium and you haven’t paid us anything back. What is going on?”

My tennis buddy replied, “Mom, I didn’t know you wanted your money back so quickly. We’ve been busy decorating the space and everything. I think we should have written down some parameters about how you would be reimbursed!”

The recoil

Then his mother replied, “Yes, you should have been more attentive that we pay something back every month. We worked very hard for this money and it was meant to be for this money our pension. But your father and I talked about it and we decided to forgive the $30,000 loan as a wedding gift.”

At that moment, my friend almost burst a capillary in his forehead and said, “No, Mom! After the guilt you just made me, there is no way I can accept your money!

He then rushed to his room, made some calculations and gave her a check with which he could pay off interest and principal. There was no way he was going to let his mother do that so be lord over him. He was angry.

Borrowing and lending money from and to friends and family is difficult

I am not a fan of borrowing money from friends and family. Money can often create strange power dynamics. It can also cause resentment, distrust and unhappiness.

Usually I’d rather just work more and wait longer than borrow money from friends. In the meantime, I want my parents to enjoy their wealth as much as possible during their golden years. They are frugal and need to start reduce more assets.

The more you value your friendship, the more careful you should be about borrowing money from your close friends. You don’t want to lose them!

Good friendships should mean that borrowing or lending money is fine

However, if your friendship is really great, then borrowing money might be fine. Your best friend may be willing to lend you money because he or she wants the best for you. If they can earn a higher interest rate, everyone wins.

I know that if a good friend wanted to borrow money from me, I would borrow it right away. Depending on the amount he wanted to borrow and what he wanted to borrow the money for, I could even just write it off as a gift.

I feel like I did that won the life lottery, so I’ve tried to make it my mission to help as many friends and family as possible by spreading my lottery winnings. Whether it’s sending money to my in-laws on a regular basis or giving my parents my Uber Eats account to use as often as they want, spreading the wealth feels great! It’s like creating multiple lottery winners!

It is much easier to help people you know financially than people or organizations you don’t know. But that is my next goal in giving as I enter my decumulation phase.

When Borrowing or Lending Money from or to friends is okay?

I realized something interesting about when borrowing or borrowing money from or to friends is okay. The determination is based on the amount of money borrowed or lent as a percentage of the lender’s net assets.

If a friend asks to borrow $10, you probably won’t have a problem lending the money. The lunch truck only accepts cash because their Square payment terminal is broken. You’re probably happy to just buy them lunch.

However, when your friend asks to borrow $10,000, you might start asking questions like what the heck for?! 10,000 euros is a strange amount to borrow because it is not enough to buy a car or a house. But it’s enough to buy a lot of things you don’t need, like a nice watch or a family vacation to Hawaii at a nice resort.

Size of the Loan is Important

Now imagine that your friend asks to borrow $1 million to buy a house. He needs a bridge loan because he has found his dream home and his liquidity is currently stuck in his existing home. He eventually plans to sell the house to pay you back, but it will take time.

Would you lend him $1 million? Most would probably say no.

But what if you have a net worth of $50 million and you have $20 million in cash earning 0.1% interest? You clearly have one top 1% net worth.

Borrowing $1 million is only 2% of your net worth and 5% of your total cash reserve. Your friend is also willing to pay you an interest rate equal to the interest rate on ten-year bonds, an interest rate hundreds of times higher than your current interest rate. He would set up an automatic monthly wire transfer and make it simple.

Since he’s your best friend and you’re confident he’ll pay you back, you might just go for it. You earn more interest and your friend gets what he wants: a win-win situation.

Benefits of Borrowing Money from a friend or family member

Let’s quickly discuss the benefits of borrowing money from a friend or family member. They are:

  • Usually a lower interest rate than what a bank would charge. You can get a personal loan through a credit marketplace like Credible. The rate will be much lower than what you would pay to a credit card company. However, it will be much higher than if you borrow from your friend.
  • It is easier to get a loan because you do not have to go through a bank’s underwriting process. It can take an average of 30 to 60 days before you get a loan from a bank.
  • Faster access to the money.
  • Potentially accessing a greater amount of capital than what a bank would lend.

Now let’s look at the lender’s point of view when determining how much money to lend to a friend or family member. The lender’s benefits include earning a higher interest rate and helping a friend or family member.

God knows average money market rates are usually pathetic. However, after the Fed started raising rates aggressively in 2022, average money market rates are high. Savers can easily get 4%+ on their money market accounts or 5%+ on their money market accounts Treasury bonds Today.

How much money to borrow based on net worth?

The lower the percentage that a loan represents to you net value, the greater the tendency you have to lend to your friends and family. I’m also assuming that you would never make a hard money loan to a non-friend or non-family member. Instead, you would simply invest your money in a traditional channel to try to make a return.

The question is: what should the loan limit be as a percentage of your assets? As a lender, you must always assume a certain level of default risk. Further, if your friend or family member does not pay the money back, you must decide what is the largest amount you would be willing to lose while keeping your relationship intact.

Let’s go through loan/net worth percentages to figure out how much you can lend to friends or family members.

10% or more loan-to-net worth

When it comes to investing in speculative assets, such as cryptocurrency, NFTs or penny stocks, I recommend that you limit your investments to a maximum of 10% of your investable assets. This way, if your speculative investments reach zero, you are still left with 90% of your investable assets. However, if your speculative investments become 10 pocket money makers, they will impact your returns.

Since most people don’t have 100% of their net worth in investable assets, lending out 10% or more of your net worth is very aggressive. Plus, the returns likely won’t be huge because you’ll be limited by the interest you can charge a friend or family member.

The maximum amount you can charge is probably 1-2% above what a bank would charge for a bank personal loan, business loan or mortgage. Typically, though, you’ll likely borrow at a lower rate than what your friend or family member could get elsewhere, so they could benefit. Otherwise it looks like you’re abusing it.

Meanwhile, you also benefit because you get a higher rate than you would from a typical money market account or even a CD.

Lending 10% or more of your assets to a friend or family member is far too much. That’s why I don’t recommend doing it.

5% loan-to-net worth

It feels like you are lending 5% of your assets the upper limit of how much you would ever need to lend to a friend or family member.

Let’s say you’re worth $1 million. There is €600,000 tied up in your house. $300,000 is stock and $100,000 is cash. Lending $50,000 sounds like the maximum amount you can borrow. With this amount, the interest income is not significant. But it does feel good to optimize your money.

Even if you’re more liquid with $400,000 in cash and no investments, it’s probably best to limit your loan to 5% of your total net worth. You’ll survive losing $50,000 if your friend doesn’t pay you back.

Losing 5% of your wealth in a stock market correction is part of the course. In a bear market, you can easily lose 35% of the value of your investments. But if you lose 5% of your wealth to a friend or family member, you will feel some resentment.

That is why I do not recommend lending up to 5% of your assets to friends and family.

1% loan-to-net worth: the safe loan amount

If you lend 1% of your wealth or less to a friend or family, no matter what happens, there’s no problem. Nothing will change in your life if you lose 1% of your wealth. If your friend doesn’t pay you back or takes much longer than agreed to pay you back, that’s no problem.

Let’s say you have a net worth of $10 million. $6 million, yes tied to real estate. $4 million is in liquid investments such as stocks, bond funds and cash. Borrowing $100,000 to your best friend, even for the most unnecessary reason, like buying a Porsche 911, is no problem. You’ll probably enjoy driving it too!

But if he starts showing off his new car online and completely ignores the terms of his loan, you might get angry. If you want to borrow money, keep it quiet.

If your friend had to borrow $100,000 to pay for a medical emergency, you would of course borrow that amount in a heartbeat, and probably much more. The purpose of the loan is an important determining factor.

Don’t lend more than 2% of your net worth to friends and family

There’s a big gray area between lending 1% to 10% of your wealth to friends and family. I’m saying you should have a hard limit on lending no more than 2% of your net worth to friends and family.

The spread of 1% to 2% takes into account:

  • How close you are to that friend or family member (the closer you are, the closer to 2%)
  • The probability that a friend or family member will pay you back (the higher the probability, the closer to 2%)
  • The interest rate your friend or family member is willing to pay (the higher the rate, usually the closer to 2%)
  • How liquid your net worth is (the more liquid your net worth, the closer to 2%)
  • The urgency of using your cash for another purpose (the less urgent and fewer ideas you have for using your cash, the closer to 2%)

The spread of 1% to 2% of the loan amount to net assets works as your assets grow.

Of course, if you’re a billionaire, you can afford to borrow an even larger percentage of your wealth and you’ll still be fine. But who is really going to borrow €10 – €20+ million?

Average interest rates for savings, money market, CDs

Below you will find the average deposit rates for savings, interest rate control, money market and certificates of deposit according to the F.D.I.C. The rates are constantly changing.

As you can see below, the average deposit rate is quite low, even after rates have risen aggressively since 2021. As a hard money lender, you could therefore do much better.

Average Treasury Deposit Rate, National Deposit Rate, Savings Rate per FDIC

Draw up clear loan covenants for lending money

If you plan to lend or borrow money, clear and strict loan covenants should be drawn up. The contract must include the following:

  • The interest rate and when the interest rate changes (fixed or variable based on an index)
  • Whether the loan is amortized over the course of the loan or an interest-only loan with a one-off payment at the end
  • Penalties for late payment or missed payments
  • How the loan is paid (physical check, electronic, cash, in shares, etc.)

Technology makes it easy to receive payments from anyone. It’s easy to send money via Paypal, Zelle, Venmo, or bank transfer.

As a landlord, there has been an evolution since 2003 from receiving physical checks to receiving largely automatic online payments at the beginning of each month. My new tenants even sent me their security deposit and first month’s rent from the East Coast.

Borrowing money can be a difficult situation. However, if you have a charitable person With a sufficiently large net worth, borrowing money can work well.

Make sure you follow the guidelines and create a clear contract that both parties agree on. The last thing you want is to ruin a good relationship.

Frequently Asked Questions – FAQs

What factors determine when borrowing money from friends or family is appropriate?

The appropriateness depends on the amount borrowed relative to the lender’s net worth and the purpose of the loan.

How much should I lend to friends or family members?

It’s advised to limit the loan to 1-2% of your net worth to manage default risk and maintain relationships.

What are the benefits of borrowing money from friends or family?

Benefits include lower interest rates, faster access to funds, and potentially greater capital availability.

What are the risks of lending significant amounts to friends or family?

Risks include strained relationships, resentment, and potential financial loss if the borrower defaults.

How can technology facilitate borrowing and lending transactions?

Utilize platforms like Paypal, Zelle, or Venmo for easy and secure financial transactions.

What should be included in a loan agreement when borrowing or lending money?

Clear loan covenants should cover interest rates, payment terms, penalties for late payments, and the payment method.

Sources & Idea Inspirations:

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